The Art of Short Selling - Shortcomings

The short sellers post price run-up exercise is to determine where the clues failed, why the price levitated, and why a normally accurate trail sign was misleading.

Three Short Sins: Sloth, Pride, Timing

Sloth
The first and biggest reason for failure in stock selection on either the short side of the long side is too little work. Usually, sloth is prompted by shorting someone else's idea.

Pride
Hubris is manifest in two primary analytical errors: (1) the sudden use of rigid formulas, and (2) the short sale of good companies.

Shorting a good company is always risky. A good company is a company with smart management who pay attention to business trends and customers and who have financial statements reflecting that unlikely blend. A valuation short is no different than a market bet.

Timing
The timing problem is the single biggest argument against individuals short selling - it throws off the risk/return relationships and suggests that individuals should use the discipline for selling or not owning stocks rather than for short selling. Investor ebullience can keep a stock price up for years in spite of no earnings, even no product. The second reason for the timing problem is the ability of investment bankers to sell another round of financing despite a seriously flawed corporate business plan. Continued flows of financing can keep a dead company on a respirator for years. In some instances, the lag time between the discovery of a fatal flaw and the demise of the company results in a change in the macroenvironment that bails out the troubled short sale candidate. Shorts all too often fail to realize how long debt takes to sink a company when the business environment is good. Almost every short position lasts too long for sellers.

One way to tweak timing is to wait until a stock cracks to short initially, after the first drop when the earnings and price momentum have slowed.

Commodities
It is easier to find fundamental balance sheet flaws than to trade grain prices. Make sure any short bet is on the company and not the commodity.

Tech Stocks
Tech inventories rise when a new product is in the works. Insiders own volumes of stock and sell often and without apparent regard for company condition. Margins can contract and expand with product cycles and the pricing curve.

Squeezes
The float of a stock is of paramount importance for a short position. Short slamming tactics do not work well for a company with a large float and a heavy Wall St following.

Complexity
Many short sellers fall in love with their own analysis, particularly if it is clever or extremely complex.

Lastly
The mistake is always shorting the company that's not that bad. The analyst has to be convinced that the core business will be overwhelmed by the problem and not just a hiccup. You can hide disgusting accounting practices with growth for a very long time.